What a difference a month makes! We had the sharpest stock market decline since the summer of 2011 (the S&P 500 was down over 9% from its September high by the 15th of October), and then recovered all of it in less than three weeks. See Figure 1. Strange to think now, but there was a lot of money poised to sell if the S&P would have fallen 15 points more (less than 1%) than it did. If the S&P 500 had fallen below 1805, the sell-off would have exceeded 10%, been a lower low to the mid-April correction, and broken the uptrend line from 2011. Each of these would have triggered sell stops from traders. I bring this up because the S&P 500 closed the day at 2073 on November 26th and selling pressure is all but gone. We have been conditioned over the past 6 years to be momentum traders and/or dip buyers. We are hypersensitive to the price of stocks, but have no idea as to their value.
S&P 500 1/1/14 – 11/28/14, Source: Stockcharts.com
In theory, stock prices are determined by the absolute level and growth rate of earnings and cash flow (discounted by future inflation expectations). On that basis, stock prices would appear to be expensive today unless corporate profit growth is robust while future inflation remains modest. It should not be possible for this ideal situation to persist over the long term, because growth should eventually force up the price of both materials and labor (thereby hurting profit growth). In effect, therefore, in continuing to push stocks prices up we are pricing in a future scenario that cannot occur.
It is more likely, however, that stock prices are being supported by the widely shared belief that in a world of easy credit and suppressed interest rates, stocks are the only investment worth holding. We all know that interest rate suppression must end sometime, but we all believe we are safe from a major stock meltdown until that point arrives. In this way we have transitioned from being investors to traders/speculators. We know buy-and-hold is going to run into a very rude shock at some point, but (presumably) we believe we will make proper adjustments to protect ourselves when that time occurs. Many market observers, from the Wall Street Journal’s Jonathan Clements to GMO’s Ben Inker, have made compelling cases why stocks cannot appreciate at their long term average of 9-10% from these valuations. Inker suggests we will either have the “purgatory” of lower returns for an extended period of time or the “hell” of a third large market decline that restores normal stock valuations.
Much is made of “seasonality”, or the tendency of the market to perform better or worse at certain times. Stocks have a pronounced tendency to do better in the November-January time period than they do in the May-June or September-October time periods, for example. We are all hearing (ad nauseum) about the presidential election cycle and how stocks almost never decline in the third year of a president’s four year term. Maybe so, but bears can play this game too. Every seventh year going back to 1966 (save 1980) has been underwhelming at best. 1966 ended the secular bull market which began in 1949. 1973 saw a decline of more than 30%; 1987 saw a 33% plunge in October; 1994 was slightly positive but bonds their worst year since 1981. I’m sure we all remember 2001 and 2008. 2015 is going to break one trend and continue the other but we don’t know which. The point is, if you mine past data hard enough you can always find something, but it just might turn out to be fool’s gold.
Energy Market Update
Energy prices continue to fall as global demand falls and global supply continues to grow. Oil producers convinced themselves that oil could not go below $90 for very long, because production would quickly fall below demand. Having done so, they committed to projects based on expectation of $100 oil. When prices began to fall, it was assumed that others (most likely Saudi Arabia) would cut production in order to preserve the price level, so hardly anybody cut much production. Inventories continued to grow, therefore, increasing the downward pressure on prices. The Saudis did not cut production as many assumed. Two explanations have been ventured. One is that they want to hurt Russia for supporting the Assad regime and at the same time make fracking in America less attractive. The other is that they realize that the Middle East instability premium (the extra $15-20/bbl the world was willing to pay to ensure they wouldn’t be cut off from oil in the event of a military crisis) was going away and they would rather sell oil at $85/bbl today as opposed to $72/bbl in the future. (Keep in mind that Iraq and Libya are currently producing oil at all-time high levels despite major unrest. The upshot is that you do not want to be overweight energy in your portfolios. Instead, you want to be long oil consumers – transportation stocks, chemical stocks, and economies that import oil such as Japan, India, and Turkey.
Foreign Investing Update
It is important to note that much of the relative performance difference between the U.S. stock market (+13.5% YTD, S&P 500) and world stock markets (-2.2% YTD, MSCI EAFE) for dollar-based investors is the exchange rate. The dollar is up 8.3% so far this year, so foreign markets in local currencies are up over 6%. Mutual funds that hedge their currency exposure include FMI International (FMIJX) and Tweedy Browne Global Value (TBGVX). In the ETF world DXJ owns Japanese stocks but shorts the Yen, and HEDJ owns European stocks but shorts the Euro.
On March 10, 2000 the NASDAQ Composite Average made its all-time high close of 5048. It is currently within 6% of that milestone at 4758. See Figure 2. Gigantic gains by its biggest stocks (Apple up 47% and Microsoft up 27%) are behind the surge this year. I wonder if climbing above 5000 will mark the end of this NASDAQ bull market as well.
The Economic Cycle
In a normal economic cycle, increasing economic growth would put upward pressure on interest rates but also improve corporate balance sheets. As a result, high yield bonds would do much better than government bonds. This has not been the case in 2014, especially in the last six months. The only explanation I can conceive of for this is that investors do not believe that the stock market reflects the health of the global economy. In other words, global deflation is the most important story in the world right now, and as a result, bond investors prefer quality. Stock prices are not a proxy for global economic health but instead a reflection of massive central bank liquidity. A lot of experts I read would feel much better about the global economy if interest rates would modestly rise.
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